DeLong Smackdown Watch (Slope-of-the-LM-Curve Edition)

I read your blog post today on John Cochrane’s new article, and I think you are misreading him.... Look at the first paragraph in the section entitled “A monetary argument for fiscal stimulus.” In the end, John concedes that, in principle, fiscal stimulus can help by, among other things, increasing the velocity of money (though he doesn’t use that terminology). He only argues that it very unlikely to be done in such a way that it would work, and that there are huge risks associated with doing it wrong.

He also disputes the notion that monetary policy can’t help when short-term interest rates are zero by proposing that the Fed buy corporate debt and sell Treasuries.

I would be interested to see how you respond to his actual arguments, rather than the straw man argument that he himself sets up and knocks down...

And:

With respect, I still don't think you are disagreeing with him in this regard. "People pathologically sitting on cash" is just another way of saying the velocity of money is lower than what it needs to be to have full employment. What else could it possibly mean? If demand for cash and cash equivalents is abnormally high, then money is going to be sitting idle in demand deposits and t-bills and not moving around in transactions...

The passage at issue is:

Cochrane: A monetary argument for fiscal stimulus, logically consistent but unpersuasive: My first fallacy was “where does the money come from?” Well, suppose the Government could borrow money from people or banks who are pathologically sitting on cash, but are willing to take Treasury debt instead. Suppose the government could direct that money to people who are willing to keep spending it on consumption or lend it to companies who will spend it on investment goods. Then overall demand for goods and services could increase, as overall demand for money decreases. This is the argument for fiscal stimulus because “the banks are sitting on reserves and won’t lend them out” or “liquidity trap.”

In this analysis, fiscal stimulus a roundabout way of avoiding monetary policy. If money demand increases dramatically but money supply does not, we get a recession and deflation. If we want to hold two months of purchases as money rather than one months’s worth, and if the government does not increase the money supply, then the price of goods and services must fall until the money we do have covers two months of expenditure. People try to get more money by spending less on goods and services, so until prices fall, we get a recession. This is a common and sensible analysis of the early stages of the great depression. Demand for money skyrocketed, but the Fed was unwilling or, under the Gold standard, unable, to increase supply.

This is not a convincing analysis of the present situation however...

I think it depends on how you interpret Cochrane's "pathologically:"

If you want to say that people or banks are "pathologically sitting on cash" most of the time, so that most of the time an increase in the short safe nominal interest rate will increase the economy's inside money supply (without any action by Federal Reserve) and also increase the economy's velocity of inside money, then my correspondent is right.

If you want to say that the state of things in which people are "pathologically sitting on cash" is unusual, exceptional, and, indeed, pathological--defined as "extreme, excessive, and markedly abnormal"--than I am right.

There also is, I think, a failure to divide up the world in the same way. I distinguish between policies of:

Pure inflation--the government prints up a lot of money and spends it to expand the outside monetary base and the total nominal value of outstanding assets to drive the price level up and induce a flight from nominal assets to real commodities.

Credit stimulus--the central bank or the finance ministry do other things to increase the capitalization or otherwise improve the functioning of financial intermediaries or to reduce the amount or improve the characteristics of the credit-market assets that the private sector must hold.

Fiscal policy--the government borrows and spends.

I think I know how to analyze (1), (2), and (4). I think we shouldn't do (1) (at least not yet). I think we have done (2) and can't do any more of it and expect it to have any effect. I think we should do (3) and (4) in some linear combination--but I have a hard time thinking about (3) because I am Bear of Little Brain.

Cochrane doesn't seem to cut the world up this way. He seems to believe, or perhaps to be very close to believing, that anything that affects any of (a) the outside monetary base, (b) the money multiplier, or (c) the velocity of inside money is "monetary policy"--in which case it is tautologically true that only monetary policy affects spending, but I don't find that terribly useful.

Comments

I read your blog post today on John Cochrane’s new article, and I think you are misreading him.... Look at the first paragraph in the section entitled “A monetary argument for fiscal stimulus.” In the end, John concedes that, in principle, fiscal stimulus can help by, among other things, increasing the velocity of money (though he doesn’t use that terminology). He only argues that it very unlikely to be done in such a way that it would work, and that there are huge risks associated with doing it wrong.

He also disputes the notion that monetary policy can’t help when short-term interest rates are zero by proposing that the Fed buy corporate debt and sell Treasuries.

I would be interested to see how you respond to his actual arguments, rather than the straw man argument that he himself sets up and knocks down...

And:

With respect, I still don't think you are disagreeing with him in this regard. "People pathologically sitting on cash" is just another way of saying the velocity of money is lower than what it needs to be to have full employment. What else could it possibly mean? If demand for cash and cash equivalents is abnormally high, then money is going to be sitting idle in demand deposits and t-bills and not moving around in transactions...

The passage at issue is:

Cochrane: A monetary argument for fiscal stimulus, logically consistent but unpersuasive: My first fallacy was “where does the money come from?” Well, suppose the Government could borrow money from people or banks who are pathologically sitting on cash, but are willing to take Treasury debt instead. Suppose the government could direct that money to people who are willing to keep spending it on consumption or lend it to companies who will spend it on investment goods. Then overall demand for goods and services could increase, as overall demand for money decreases. This is the argument for fiscal stimulus because “the banks are sitting on reserves and won’t lend them out” or “liquidity trap.”

In this analysis, fiscal stimulus a roundabout way of avoiding monetary policy. If money demand increases dramatically but money supply does not, we get a recession and deflation. If we want to hold two months of purchases as money rather than one months’s worth, and if the government does not increase the money supply, then the price of goods and services must fall until the money we do have covers two months of expenditure. People try to get more money by spending less on goods and services, so until prices fall, we get a recession. This is a common and sensible analysis of the early stages of the great depression. Demand for money skyrocketed, but the Fed was unwilling or, under the Gold standard, unable, to increase supply.

This is not a convincing analysis of the present situation however...

I think it depends on how you interpret Cochrane's "pathologically:"

If you want to say that people or banks are "pathologically sitting on cash" most of the time, so that most of the time an increase in the short safe nominal interest rate will increase the economy's inside money supply (without any action by Federal Reserve) and also increase the economy's velocity of inside money, then my correspondent is right.

If you want to say that the state of things in which people are "pathologically sitting on cash" is unusual, exceptional, and, indeed, pathological--defined as "extreme, excessive, and markedly abnormal"--than I am right.

There also is, I think, a failure to divide up the world in the same way. I distinguish between policies of:

Pure inflation--the government prints up a lot of money and spends it to expand the outside monetary base and the total nominal value of outstanding assets to drive the price level up and induce a flight from nominal assets to real commodities.

Credit stimulus--the central bank or the finance ministry do other things to increase the capitalization or otherwise improve the functioning of financial intermediaries or to reduce the amount or improve the characteristics of the credit-market assets that the private sector must hold.

Fiscal policy--the government borrows and spends.

I think I know how to analyze (1), (2), and (4). I think we shouldn't do (1) (at least not yet). I think we have done (2) and can't do any more of it and expect it to have any effect. I think we should do (3) and (4) in some linear combination--but I have a hard time thinking about (3) because I am Bear of Little Brain.

Cochrane doesn't seem to cut the world up this way. He seems to believe, or perhaps to be very close to believing, that anything that affects any of (a) the outside monetary base, (b) the money multiplier, or (c) the velocity of inside money is "monetary policy"--in which case it is tautologically true that only monetary policy affects spending, but I don't find that terribly useful.

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